Yield curve inversion and what it means for the market
By Tan Teck Leng, Senior Fund Manager, Phillip Capital Management
An inverted yield curve is an interest rate environment in which long-term bonds have a lower yield than short-term bonds (assuming all other things are equal eg. credit quality). This type of yield curve is often considered to be a predictor of economic recession. It is the reason why markets went into some volatility recently when there was such an inversion between the 3-month US bill yield (above 2.4%) and the 10-year US Treasuries yield (below 2.4% in late March 2019).
Why is this so? Bond investors are typically considered to be savvy readers of the economy, and in a looming recession, knowing that interest rates are to trend lower, bond investors are more willing to invest in longer-term securities immediately to lock in current higher yields, hence bidding their prices and lowering their yields (yields move opposite to prices). With less demand for shorter-term bonds, their yield remains stagnant or might even go up. Hence with dropping long-term bond yields and rising short-term bond yields, this process if extended leads to an inverted yield curve.
There are a few counter-points against this to note:
- The recent inversion has happened between the three-month US bill and 10-year US bond yields. Typically, institutional investors would reference more to the 2 year-10 year yield spreads, or the 2 year-30 year yield spreads for the inversion signal.
- While an inverted yield curve is a potential indicator of upcoming recession, it is also worth noting that it may not necessarily be the case. For example, since 1954 a yield inversion of the 3-to-5 year US government yield curve has happened 73 times, while the economy has only had 9 recessions — too many false positives (Fundstrat Global Advisors, Dec 2018).
- Based on the original research case for the yield inversion as being an indicator of recession, only an inversion of at least three months is a reliable recession indicator. The inversion of the 3 month-10 year rates has actually reversed itself since late March, and we are now back to a (slight) positive yield curve again. The fact is that recent data from China (positive production and exports data) and the US (positive employment data) have revived some economic confidence once again.
- Indeed, what we consider as the most important point is this: stocks actually still continue rising considerably after a yield curve inversion has taken place. For example, the S&P 500 has risen for over 1.5 years on average following an inversion before starting to fall, based on data since the 1950s. Another more recent case: the US yield inversion happened in early 2006, but global equity markets subsequently had one of the strongest bull markets over 2006-07 before finally peaking in late 2007.
Still, the fact is that with the US Federal Reserve halting their rate hikes, the expectation is now that the upward pressure on global interest rates is now reversing, and consensus is now tilting towards a “lower for longer” (lower growth, low interest rates) global environment in the medium term. Based on recent experience over the early 2010s when such an environment persisted, the following investment types performed well:
Bond Market Signal
Stocks have tended to keep rising after inverted yield curve
- High yield quality stocks. In a low-growth environment, income is more dependable than capital gains. High-yield equities will also be attractive given their high yield spread over risk-free rates that are expected to have peaked and heading downwards. But high yield is not good enough; the yield must also be sustainable and for that it is important to ensure that the companies behind the stocks have strong fundamentals, hence quality is important.
- An example would be the Phillip SING Income ETF. It considers company quality along two aspects: business quality and financial quality. The top constituents within this ETF comprise blue chips such as the three Singapore banks, SGX, Singtel, major REITs such as Capitaland Commercial Trust and Capitaland Mall Trust, ST Engineering and SATS.
- The Singapore market has rallied lows already in 2019, but in terms of valuation it is still attractive when compared to its own history. For example, on a price-book basis, the benchmark Singapore stock index is still trading at 0.5X standard deviations below 5-yr average. See below:
- REITs. Property is also one of the sector beneficiaries from declining rates. In particular, REITs will be attractive in such a “lower for longer” environment given their high dividend yields. REITs benefit from lower interest rates fundamentally because they will be able to finance properties at lower interest rates going forward. In times of uncertainty, REITs also enjoy resilience given their locked-in leases (eg. industrial REITs can be 5 years or longer, retail and office leases around 2-3 years) which ensures steady cashflow as long as tenants do not default.
- For example, the Phillip SGX APAC Dividend Leaders REIT ETF, investing in Asia-Pacific REITs, has delivered 13.4% total return in 2019 already, while the Singapore focused Lion-Phillip S-REIT ETF has delivered 12.5% over the same period (all in SGD terms). That is not all: in a bad year for equities such as 2018, the former only dropped 3.0% while the latter declined a modest 5.4%.
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